A New Financial Crisis On The Horizon

FDIC chairwoman Sheila Bair said recently that she was "very worried" about the nation's biggest banks not lending enough and instead borrowing dollars cheaply to buy higher yielding assets such as stocks or commodities. She said, "I don't see much money going out (from banks). I see a lot of carry trade." If she is worried, shouldn't we be worried too? (Learn more in The History Of The FDIC.)Carry TradeThe carry trade isn't new. It's a simple strategy that everyone can understand. Just borrow at a low rate, invest at a high rate and pocket the difference. This is essentially how banks make money. They pay little to depositors, then loan money out at much higher rates. The difference is theirs to keep. So, if you keep $1000 in your checking account and $2000 in your savings, paying almost nothing, but have $3000 on a credit card at 18%, the bank is making 18% for being the intermediary.

Interest Rate ImpactWhen interest rates are near zero, as they are now in the U.S., it's quite appealing to institutional investors. This is because almost any other investment will pay more, there is little to no interest due on the debt and they can leverage the investment by borrowing more. For example, borrowing dollars today costs close to nothing. Almost every investment category is up from the bottom, some more than others. The result is a tidy gain. (Learn more in How Interest Rates Affect The U.S. Markets.)

But add to that leverage and you can see that profits for some firms are more than tidy. At the height of the bubble, some banks were leveraged more than 40 to one. That means that for every dollar invested, they borrowed 40 more. So if they could work a carry trade in which they were paying almost no interest on the borrowing, whatever they made on the lending would be 40 times bigger with leverage.

Why It Matters to YouYou should care because the carry trade isn't risk free. If nothing changes, the trade continues to make handsome profits. But when things change, the trade can reverse sharply. We should all be familiar with leverage by now, given the recent debacle. In fact, it's so fresh in our minds that we can't even think about going through it again so quickly. But if the head of the FDIC is "very worried" about a carry trade, it's clear some haven't learned the lesson of high leverage.

Currently, the dollar is negatively correlated with the stock market. When the dollar falls, the market rises, and vice versa. If we consider the falling dollar, we can see an even larger carry trade. The profit of just borrowing, or shorting, dollars and converting them to other currencies is enough to get the attention of many investors, but invest in these rising markets and leverage that up 40 or 50 times and it starts to become real money.

But the value isn't there. The price of an asset doesn't have to reflect the true value of that asset and many people feel that the market is overpriced. So if the speculators that are pushing up the market due to the carry trade reverse and want to get out, there's no support from value investors insight. Add to that the possibility of highly correlated assets moving at once across markets and a sharp decline is possible. (For more on market failure, check out our Crashes Tutorial.)

Unsustainable SituationAnother reason you should care is because this situation won't continue forever. While one can't be certain of when this phenomenon will end, it's not sustainable, as the dollar won't fall to zero and buyers, even with leverage, will become exhausted. Once there is a hint of inflation, the massive liquidity that has fueled this trade will start to be mopped up by the Fed. That will almost certainly impact this trade. This may not happen for awhile, but interest rates aren't going to be zero forever. The longer this goes on, the bigger the fall.

One last reason that this should concern you involves banks not lending money. If banks aren't lending money to companies and individuals that are spending it, then there is little hope for the economic recovery. The securitization market, where banks collateralize their loans and sell them, is anemic. So if banks aren't lending, there isn't much lending going on which means there isn't much economic activity going on.

Bottom Line: Reason For WorryThe job of banks is to be an intermediary between borrowers and lenders. That creates an economy that uses its capital in a productive way. If banks are just investing it in other paper to make a profit for themselves, they aren't banks at all, they are investment firms of hedge funds. Given the repeal of Glass-Stiegel and mergers of banks and investment firms, it's only reasonable to assume that banks would act like investment firms. But if banks are acting like investment firms, who's acting like banks? Now that's something to be "very worried" about.